Pay Attention to the Bond Markets

Fed begins testing ‘reverse repo’ trades
By Michael Mackenzie and Henny Sender in New York
The Federal Reserve has begun conducting small-scale tests of trades called “reverse repos” on Wall Street that would enable it to drain cash from the financial system once it decides to roll back its current extraordinarily loose monetary policy.
In a reverse repo – shorthand for a “reverse repurchase agreement” – the Fed sells assets such as Treasury securities to dealers for cash with an agreement to buy them back at a slightly higher price at a later date. In the process, bank reserves are drained from the financial system.
This technique helps the Fed maintain its short-term interest rate at a desired level. In December 2008, when the central bank established a target range for the federal funds rate of 0 to 0.25 per cent, it stopped conducting reverse repos to influence rates.
However, dealers say in recent days, the Fed has conducted reverse repo tests in the so-called tri-party repurchase market, in which custodian banks such as Bank of New York and JP Morgan act as intermediaries.
The tests are not a sign that the Fed is about to drain reserves on a large scale. That would require a decision by the Federal Open Market Committee to scale back its generous liquidity support for the financial system. Such a move is not expected before 2010 at the earliest.
In remarks prepared for delivery last night in Washington, Ben Bernanke, Fed chairman, said: “My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period.”
He added: “At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”
In such an event, Mr Bernanke identified large-scale reverse repos with “banks, the GSEs [government-sponsored enterprises], and other institutions” as a tool that could be used to drain bank reserves.
The Fed has been exploring the possibility of conducting reverse repos with the money market mutual fund industry, via the tri-party market, according to market participants.
Since the onset of the financial crisis, the central bank has created $800bn in excess reserves, and many economists believe this poses a long-term inflation risk.